12 January 2020

The prospect that this week the USA and China will sign Phase 1 of a trade deal has buoyed financial markets. Of course, I will assess the impact of the agreement as details emerge. However, initial optimism is warranted if the plan represents the first step towards a comprehensive trade agreement (even if the final product takes years to negotiate). Indeed, recent PMI reports suggest the slump in manufacturing activity in both countries (and economic activity more broadly) may be turning the corner.

In China’s case, especially, this assessment may be premature. To be sure, American protectionism has taken its toll on Chinese exports and investment. However, the prospect of a tade war has not been the main source of the nation’s slumping economic performance. Rather, the headwinds posed by China’s two inevitable structural adjustments — deleveraging and the shift to a consumer/service sector led growth model — have been even more important.

Therefore, assessing China’s propects in 2020 and beyond requires an appraisal of the progress of these transitions. To be sure, China’s recent stimulative monetary and fiscal stance has helped to offset the adverse economic consequences of the trade dispute. However, these same policies appear to have impeded progress on these other vital adjustments. Crucially, these delays may lead to a more prolonged, and potentially more disruptive, adjustment in coming years. China’s slowdown is still in an early phase, and GDP growth will slow to less than 5% within 24 months.

Trade War: Diverting Trade Softens the Blow

Clearly, the trade war has taken a toll on China’s manufacturing sector. Indeed, after growing 10% in 2018, Chinese exports declined 0.3% last year (Chart above). Not surprisingly, higher US tariffs resulted in a 13% decline in sales to the USA — China’s top trading partner. As exports to the USA as a percent of Chinese GDP are 4 times greater than American exports to China, it is easy to understand China’s desire to ease trade tensions.

However, China’s ability to divert foreign sales to new destinations helped minimise the impact of US tariffs. Exports to ASEAN countries and Africa, for example, have been particularly resilient. Sales to Europe also rose.

Even so, sales to non-US markets expanded only a modest 2.5% in 2019. It is also possible that stronger exports to ASEAN may have simply been re-exported to the US market — hardly the outcome sought by the Trump Administration. Likewise, higher Chinese sales to low-cost Asian markets appear to represent early, successful steps to re-organise the region’s global manufacturing supply chains in reaction to higher American tariffs.

Perhaps surpisingly, despite the trade conflict and lower exports, China’s external sector actually appears to have contributed positively to overall GDP growth in 2019, as imports slumped nearly 5%. If, as expected, the anticipated Sino-US trade deal involves China’s pledge to import additional US agricultural products and other goods and services, China’s foreign sector is likely to become a headwind to GDP growth in 2020.

Deleveraging: Heading in Reverse

Chinese policymakers have aggressively eased monetary and fiscal conditions to offset the consequences of the trade dispute, and to boost slowing domestic consumer and investment spending (Chart above). What has been the impact of these programs on the government’s strategies to both reverse the huge borrowing binge following the Global Financial Crisis and encourage a consumer-led growth model?

Households: Mortgage Borrowing Supports Consumer Spending

The Chart above illustrates that rather than declining, leverage remains on the rise. There are lessons to be learnt in each sector. For example, higher household borrowing is less troubling, as it supports the long-term aim to boost consumer spending. In addition, while the following Chart shows that household debt is now high compared to other emerging nations, the ratio is in line with more advanced economies. What is worrisome, however, is the pace of the dramatic rise in consumer (largely mortgage) borrowing since the GFC fueled. This could pose future risks to financial institutions, if growth slows sharply. In addition, there may be a limit to how much further credit-fueled consumer spending can be relied upon to offset weakness elsewhere in the economy.

Corporate Borrowing: Rising Again, Fueled by SOEs

On the other hand, trends in the corporate sector are considerably more worrisome. After showing signs of peaking in 2016, last year’s monetary stimulus again has led to a renewed increase in corporate leverage (see earlier Chart). Furthermore, the following Chart illustrates that even before the recent surge in business borrowing, corporate debt levels were amongst the world’s highest.

If this were not bad enough, most of the new lending has been to State-owned enterprises (SOEs). This trend is at odds with the government’s aim to reduce the overall investment/GDP ratio, and especially that of these less-profitable firms (next Chart).

Chinese corporate deleveraging is inevitable. Attempts to delay the process through easy money or state-directed lending runs the risk of making the eventual adjustment more prolonged, painful, and disruptive. The following Chart illustrates that other countries with similar levels of private sector debt either experienced deep recessions or protracted economic slowdowns during their deleveraging campaigns.

Public Sector: Running Out of Fiscal Space?

In addition to easy financial conditions, China has used expansive fiscal policies to boost growth following the GFC and in response to the trade war. That makes sense, as the earlier Chart illustrates the Chinese public sector deficit was small, and the government debt was low. After years of borrowing, however, the following two Charts show that conditions are now less favourable. Moreover, if you accept the IMF’s broader definition of the “augmented” government’s financial position, China’s fiscal space to boost growth further may be considerably more limited than widely imagined.

Transition to Services: Headwind for Potential GDP

China’s previous export-led development model produced decades of strong growth and dramatic poverty reduction. However, as the size of China’s economy has expanded sharply, government authorities have concluded correctly that this model was no longer sustainable. The Chart above highlights the progress in transitioning the economy from industrial to service activities. Despite this success, the service sector remains considerably smaller than in more advanced economies, so the process still has considerable room to run.

As the Chart above also illustrates that productivity in the service area lags well behind the factory sector, the economic rebalancing will inevitably lead to slower potential GDP growth in the future. In addition, the following Chart indicates tertiary sector efficiency has slowed sharply in recent years, largely as promised reforms in the service sector have not been delivered promptly.

The next Chart also illustrates that productivity convergence with the USA is considerably more advanced in the industrial area than the service sector — a pattern that is forecast to persist.

These trends have important implications for both Chinese and American policymakers. In China, more aggressive service sector reforms aimed at boosting productivity are vital. Otherwise, the desired economic rebalancing will inevitably lead to a structural slowdown in potential GDP growth. Furthermore, the current mix of low interest rates and weak RMB may impede the required reallocation of resources from industry to the service sector.

For the USA, the politically motivated focus on boosting US agricultural exports in the trade negotiations is short-sighted and unambitious. American attention should focus on sectors in which Chinese productivity and growth is accelerating — technology, health care, education, and finance — or areas where future Chinese service sector reform might unleash huge new opportunities, e.g. retail.

Hong Kong: Quick Thought

Developments in Hong Kong need to be dealt with elsewhere in more detail. However, the sharp collapse in HK retail sales (down 25%) and tourist arrivals (down 50%) highlight the impact of the ongoing political crisis. While the situation is a wildcard, Hong Kong’s slump will pose economic and political challenges for Chinese authourities in 2020 — with risks only to the downside.

Strategic Conclusions

• The adverse impact of deleveraging and economic rebalancing have been more important driver of China’s GDP performance. Agreement of Phase 1 of a trade deal is positive, but is unlikely to prevent Chinese growth from slipping below 5% in the next 24 months.
• A comprehensive trade agreement would take years to achieve. If you need convincing, just look at Brexit! I am deeply sceptical.
• More aggressive service sector reform — aimed at boosting productivity in this area — is vital to prevent this structural slowdown.
• The combination of easy money and a weak RMB may be impeding deleveraging and the reallocation of resources from industry to services. This may result in a more prolonged, disruptive adjustment in the future.
• CNY may rally further near term, as a trade deal will involve postponement of planned US tariff hikes. However, weaker-than-expected Chinese growth may prompt additional monetary stimulus in 2020. At some point, addition CNY/$ weakness is likely (perhaps towards towards 7.5).
• I expect the US Federal Reserve to remain on hold for much of 2020, and anticipate the USD will weaken somewhat this year. Even a limited trade truce should help Emerging markets outperform in 2020, despite the ongoing adjustments in China’s economy.